Government Bonds No Longer a “Risk Free” Investment

12/19/2011 11:25 am EST

Focus:

Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

After one of the most volatile and tumultuous years that investors have experienced in the last twenty years, even including the unprecedented events of 2008-09 or the Asian Crisis of 1997-98, one conclusion seems increasingly obvious to the outside observer. It is that the role of government debt has changed from being the "risk-free" asset against which all other possible investments should be measured. Investors need to seriously consider alternatives to automatically using government bonds as their default low-risk investment.

There are several reasons for doing so, but let's take the most obvious one first. Government bonds are regarded as being without risk as there was felt to be no danger of default by a developed economy. Therefore, although purchasing a government bond involves taking interest rate risk (i.e. the chance that interest rates will rise after the bond is purchased, making the price of the bond fall) there was no credit risk (the chance of not being repaid in full when the bond matures). The events of the last eighteen months in Europe have seen this widely held belief come under pressure, as it has become apparent that there is indeed the possibility of default by a developed economy.

In fact, the most recent bailout package for Greece in October 2011 saw private sector bondholders forced to agree to a "voluntary" 50% reduction in the value of their bonds. To add insult to injury, because the agreement was supposedly voluntary, the agreement did not trigger the bond-owners' insurance they had purchased against default, their Credit Default Swaps (CDS)! As a result, private sector bond-owners began selling off other countries where there concerns over possible default, including the rest of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) causing ten year bond yields in Italy and Spain to exceed 7%. This was the level at which Greece, Ireland, and Portugal had to seek bailouts over the last year, as their deficits became impossible to finance at such high interest rates.

Therefore, investors have come to realize that even relatively highly rated government bonds issued by developed countries do have credit risk attached. To suggest that investing by domestic investors in Italian or Spanish government bonds could lead to capital losses is no longer regarded as ridiculous, and the failure of the European authorities to deal decisively with the Euro-zone debt crisis has led to such concerns spreading to such AAA-rated credits as Belgium and France.

However, the second reason that government bonds should no longer be regarded as "risk-free" applies even to those countries such as the US, Canada, Germany, the UK, and Japan, whose bonds trade at extremely low yields that have not been seen for over half a century. This is despite the fact that the US and Japan are no longer rated AAA. The highest yield available on a ten-year bond is 2.12% on a UK gilt, while US, Canadian, and German ten-year bonds each yield about 2%, and Japanese ten-year JGBs 1%. This means that the maximum return an investor in the remaining "safe" developed markets can achieve from a government bond held till maturity is 21.3% in nominal terms over the next decade and the lowest only 10%. At such extremely low absolute yields, even before taking taxation into account, it is clear that an investor will not be able to earn a sufficient return to compensate them for the erosion of their capital in real terms by inflation.

Given the high and increasing government debt levels in these countries, which are approaching 100% of Gross Domestic Product (GDP) or 200% in Japan's case, it is apparent that governments (with the probable exception of Canada, which went through its austerity program 15 years ago) must either restructure their debts through reductions in bond coupons, or default, as occurred in the 1930s, or inflate them away, as happened in the 1970s. In either case, the real value of investors' capital will be eroded, yet so fearful of equity volatility have investors become that they are willing to accept the lowest government bond yields in 65 years. The last time US ten-year Treasury bonds yielded this little in 1946, interest rates rose for the next 35 years, and bonds became known as "certificates of confiscation."

Just like bond investors in the 1940s and 1950s, who were looking back at the excellent returns they had received by investing in safe government bonds as opposed to the losses suffered by those investing in equities, with the Dow Jones Industrial Average not exceeding its 1929 high until 1954, so today's bond investors are mesmerized by the wonderful returns they have received from government bonds since 1981, when ten-year yields were over 15%. In the meantime, equity indices are no higher than they were a dozen years ago, and in real terms, adjusted for inflation, equity investors are back to mid-1990s levels, ignoring dividends.

While our sub-conscious biases make it extremely hard to ignore past performance when making investments, assuming logically that bond investors are concerned with preservation of capital and the yield that it provides, it would make much more sense to purchase investment grade quality corporate bonds issued by blue chip companies. Apart from receiving a yield 1.5-3% higher than that on a government bond, blue chip companies, especially global multi-nationals, have much better quality balance sheets and ability to service their debts than virtually any developed country. As owners of senior obligations of the company, bondholders will be paid their interest even if slower growth or another bad recession leads to dividends being cut or suspended. While credit rating agencies refused to rate companies more highly than their home country, this is no longer the case. Investors looking for genuinely low-risk investments should focus on high grade corporate bonds rather than supposedly "risk-free" government bonds.

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